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Senator Silvina Marcela Garcia Larraburu of the opposition Victory Front looks at her phone during a session to vote on an income tax reform bill at Congress in Buenos Aires, Argentina, December 21, 2016. REUTERS/Marcos Brindicci - RTX2W369
Up Front

How to deal with growing fiscal deficits? Are higher taxes a smart option?

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Ever since the global financial crisis of 2007-2008, countries around the world have seen their fiscal deficits grow in an almost unstoppable way. Is raising taxes a good way to combat these ballooning deficits?

Authors

C

Carlos Vegh

Chief Economist for Latin America and the Caribbean - The World Bank

Former Brookings Expert

Guillermo Vuletin

Senior Economist - Office of the Chief Economist for LAC, World Bank

Figure 1 shows the average overall fiscal balance for a global sample of 188 developing and industrial countries based on data from the International Monetary Fund. The average overall fiscal balance has shifted from positive values during the peak years preceding the global crisis to large and growing negative values since 2008 (see black line). In spite of occasional increases in fiscal balances, the trend depicted by the red dotted line points to an unequivocal negative trend. In fact, for the year 2016, just 16 out of 188 countries (less than 10 percent) are expected to show positive fiscal balances. Even with the IMF’s “optimistic” data for the years to come, fiscal balances are still to remain at negative values going as far as 2020. In fact, even in this quite hopeful scenario, for the year 2020, just 38 out of 188 (i.e., about 20 percent) of countries are expected to show fiscal surpluses.

Figure 1: Overall fiscal balance around the world

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So far, most of these countries, particularly in the developing world, have been able to finance their way out of growing fiscal deficits by increasing their public debt. However, several factors limit the continuation of this strategy in the medium run, including an increase in sovereign spreads (the difference between the interest rate on a U.S. Treasury issue and a similar issue of another government), a global economic slowdown that seems to be secular rather than temporary, concerns over the sustainability of growing debt stocks, and the prospect of further interest rate hikes by the Federal Reserve.

The obvious question then becomes how to best deal with growing fiscal deficits. One option would be to reduce the fiscal deficit by cutting government spending and increasing efficiency. While tough times provide the political will to increase efficiency and carry out medium to large scale spending reforms, it is not obvious, particularly in the least developing world, that reducing spending is a smart policy in countries with important social, developmental, and infrastructure gaps. Such is the case of most countries in Central America and the Caribbean as well as low income countries in Africa and Asia. Moreover, given the rigidity of most public spending, cutting spending would involve long periods of political commitment and fiscal adjustment.

Are higher taxes a smart option? Arguments against tax hikes come in all flavors and colors. At the top of the list is the seemingly negative effect that tax hikes have on economic activity, or the so-called tax multiplier. Formally, the tax multiplier measures the effect of a $1 change in tax revenues on the level of GDP. Indeed, recent research shows that the effect of tax changes on output can be quite large. In fact, based on a broader discussion on the effects of fiscal adjustments, former IMF Chief Economist Olivier Blanchard has argued that fiscal multipliers in the Eurozone have been underestimated by the IMF and others and hence that the contractionary effects of fiscal austerity have been considerably higher than initially expected.

In our forthcoming paper, titled “Non-linear effects of tax changes on output: a worldwide narrative approach”, we challenge the universal validity of this view. We found evidence, in line with existing theoretical arguments, that the effect of tax changes on output is highly non-linear. Under low or moderate initial tax rate levels, the impact of tax changes on long-run economic activity is very small (or virtually zero), while the impact increases in a non-linear way as the initial level of the tax rate rises. The reason behind this finding is that the distortion imposed by taxation on economic activity is directly related to the level of tax rates. By the same token, for a given level of initial tax rates, larger changes in taxes have a larger effect on output.

Figure 2 shows that when it comes to the value-added tax (VAT) rate, the most negative tax multipliers occur for high levels of both the initial tax rate and of the size of the tax rate change. In other words, the fall (increase) of output associated with increasing (reducing) revenues by $1 tends to be zero for low levels of initial tax rates and small tax changes and increases as the initial tax rate and the size of changes rises.

Figure 2: Non-linear tax multiplier

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These new findings have important policy implications given that the initial level of taxes varies greatly across countries and thus so will the potential output effects of changing tax rates. For example, changes in VAT rates of 1, or even 2, percentage points would have virtually no effect in countries with very low VAT rates (lower than 14 percent). For countries with low to moderate levels of tax rates (VAT rates between 14 percent and 19 percent), changes in VAT rates of 1 percentage point would have no effect in economic activity, but a 2 percentage points change would affect, to different degrees, economic activity. On the other hand, for countries with high levels of VAT rates (higher than 19 percent), VAT rate changes of either 1 or 2 percentage points would have significant implications for economic activity.

This implies that countries in need of higher tax rates might be able to do so without overly hurting economic activity when starting at low levels of tax rates. This is quite often the case in countries with important social, developmental, and infrastructure gaps like Guatemala, which has a VAT of 12 percent, or in commodity-rich countries whose fiscal deficits have increased as a consequence of the recent fall in commodity prices. For example, several commodity-rich countries like Nigeria and Angola have a fiscal revenue structure that depends “excessively” upon commodity revenues vis-à-vis commodities’ contribution to GDP. In Nigeria, fossil fuel revenues represent about 75 percent of total revenues but only constitute about 20 percent of GDP. In many of the countries where the fiscal revenue structure depends excessively upon commodity revenues, we often find low non-commodity tax rates (e.g., Nigeria and Angola have VAT rates of 5 percent and 10 percent respectively). Therefore, increasing VAT rates could help quickly mobilize revenues from non-commodity activities. On the other hand, the economy will suffer significantly when taxes are increased at higher initial tax rate levels. The recent increase of 1 percentage point that took place in Greece in June 2016 (VAT increased from 23 percent to 24 percent) will, in and of itself, reduce GDP by 2 percentage points by June 2018.

In sum, this novel evidence regarding the non-linear effects of tax changes on output could inform, particularly in developing countries, a smart way to solve pressing fiscal problems.

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